Your Mutual Fund Investment Portfolio: How Many Funds Should You Own?

You’ve probably heard the diversification mantra for years and that it’s a major key to successful money management. And, as many unfortunate folks have recently learned, lack of diversification can mean the difference between a nice nest egg and possibly none at all. But, are you one of those investors who tinkers with stock charting tools and collects mutual funds in the same way that other people buy things at discount stores? If three are good, then six must be better?

Your Mutual Fund Portfolio: How Many Funds Should You Have?

Friends of mine have Excel spreadsheets with several accounts and even more investments spread across 5 to 10 stock brokers and financial institutions. It’s easy to get into the rut of owning an overabundance of funds. You might have a few that you feel sentimental about and that you’ve owned for decades, and several more that you recently bought because they were listed in Forbes’ as a “must have” fund. You may even have some in your IRA that were rolled over from your 401(k) plans. But what has this accomplished? Could you possibly have diversified yourself to the point of diminishing returns and now have done more harm than good? Is your portfolio a cohesive unit working in synergy or a jigsaw puzzle scattered across your kitchen table?

So how many funds are too many? There’s really no magic number, and each investor’s situation is different. But think about how much time you spend monitoring your portfolio and keeping track of your paperwork. Mutual funds were meant to simplify investing rather than make it cumbersome and confusing.

Portfolio Rebalancing And Spending

Most good financial plans call for a specific balance of asset classes. And each year you make adjustments among your investments in order to maintain that balance so that your risk/reward profile does not get too out of hand. This means that you would sell part of the asset classes that have done well and buy more of the asset classes that have fallen behind. For those of you spending from your portfolios, you should use the same methodology — provide income from asset classes that have done well and rebalance at the same time. The more funds you own though, the more complicated this becomes: oftentimes, people don’t know how to rebalance and where to spend from because they are not sure what their actual holdings represent. So simplicity is key.

Are You Double Dipping?

What if two of your funds are large-cap and growth-oriented, and both have large holdings in the same stock? If that stock were to take a dive, both of your investments would suffer. Or worse, like a lot of funds in the same class, what if several of their top holdings are identical and they take a dive? How have you helped yourself by having two funds (or, in some cases, 3 or 4)? This duplication does not help you diversify. Rather, it is exposing a larger amount of your portfolio to similar risk. You really should be looking to hold funds that all have different characteristics and behave differently. Having near clones does not make one diversified!

After many years of investing, you may not be sure whether or not you own too many funds. This might be a good time to go over them and think about why you bought each one. Some questions to ask yourself:

Would you still buy your mutual funds today?

Have any of your mutual funds changed their investment style over the years?

How might that impact your overall financial plan?

Is there now overlap of investments within your funds that exposes you to greater risk?

Oftentimes, we own mutual funds that overlap and we don’t know it. Sometimes, funds suffer from “style drift”: it’s not uncommon for a small cap fund to change its characteristics and turn into a mid-cap or large cap over time. The same can be said for value vs growth funds.

If you are not sure, use a stock screener to find stocks (such as Morningstar.com) to categorize your funds. This will help you understand where overlap may occur and see if any of your funds have changed. Also, look at the information and semi-annual reports presented to you by your mutual fund companies and online discount brokers. Do the same company names appear in the top ten holdings of several of your funds?

The Ideal Asset Allocation Mix

If you think that your basket of mutual funds has become too overwhelming to manage or there might be investment overlap resulting in less diversification and greater risk, then consider consolidating your investments and your accounts. Most people do not need more than one IRA (unless you have a Traditional and a Roth), one taxable account, and a retirement plan through work. Three accounts should serve you just fine. If you decide you need to consolidate your investment accounts, just watch out for capital gains tax possibilities and any potential fees you may incur before you start. But, the benefits of consolidation and simplification may outweigh some costs and taxes.

Many people may wish for a direct answer to the question “how many mutual funds should you own”? If you really pressed me on how many funds you would need to be diversified, I would say between 3 and 10. Personally, I see diversification as broad exposure across all sectors and all markets. For instance, a simplified low-cost portfolio may look like an appropriate mix between:

Total US Stock Index (small, mid, large cap, growth, value, and sector representation)

Total International Stock Index (developed, underdeveloped, and emerging markets)

And yes, I left out sector funds, precious metals, real estate, etc. for a reason (although these asset classes are considered great diversifiers)! The stocks-and-bonds portfolio described above is a good starting point and serves as a pretty basic, diversified portfolio.

If you’re like me and find such a portfolio a tad bit too simple and you don’t fancy the all index approach, you may want to mix it up by breaking up some of the categories a bit. Incidentally, this approach gives you more spending and rebalancing flexibility too, but it is a bit more complex to manage:

Total US Stock Index Fund

Large Cap Growth Fund

Large Cap Value Fund

Mid Cap Fund

Small Cap Fund

Short-Term Bond Fund

Intermediate-term Bond Fund

Long-term and/or High yield Bond Fund

Total International Stock Index

Just remember, you really only need one ONE fund per category. Nothing more, nothing less. Do yourself a favor and keep it as simple as possible.

At this point in time I would do all of my own investing and not put any money in the hands of anyone else. Instead of buying a mutual fund, pick out a group of stocks yourself and add to and subtract as situations change.

S. B.January 16, 2010 at 2:43 pm

Also, if you have a lot of different accounts, it’s not very productive or cost effective to try to diversify and rebalance each account individually. It often makes much more sense to apply the diversification across all your accounts as a whole. Some accounts naturally favor certain funds and investments with their offerings, and costs are often lower if more money is applied to a single fund within an account.

For example, suppose you have 4 accounts: a regular IRA account and a Roth IRA account each with Vanguard, a 401(k) account from work with Fidelity, and another old 401(k) account from a previous employer. Generally it is a waste of money to make sure each of these accounts is properly diversified by, say, holding 4 funds in each of these accounts. Usually you can lower your costs by holding only the best deal within each account. For example, your work accounts might offer institutional class funds (with lower fees) because of pooling, and may also allow you to contribute to funds that are currently closed to retail investors. Your Vanguard accounts might benefit by holding only one fund because you might be able to avoid account minimum fees and qualify for admiral class shares.

Thus, it often makes more sense to hold your bond fund only in one account, your international fund in another, and so forth, rather than trying to hold all of those funds in every account. Your money is still diverisified in the aggregate, which is what really counts.

basicmoneytipsJanuary 17, 2010 at 7:09 am

I must admit, I contributed for years to the American Century Ultra fund as well as Bill Miller’s Legg Mason Value Trust. However, when basically 100% of the market fell in 2008 its hard to fault these fund managers for not delivering returns. However, at that point I took more control over my investing. I figured I can do no worse.

I do still own several funds, however, I have several accounts where I do my own investing.

I have my ROTH IRA in an Ameritrade account where I buy and sell stocks. I own a group of 3 stocks in that one. Also, I have a Sharebuilder account that I do some day trading in – if you call 20 trades last year day trading. I was able to hit about 25% in that account. Many mutual funds beat me last year, but I figure it forced me to do a little research and if I can hit 25% 4 out of 5 years, I will take it.

I do not know how many mutual funds are too much. I do think it is important to know what your funds are holding. For example, Bill Miller rode Fannie Mae from the 80s all the way to nothing. I got nervous and got out before it destroyed my account – glad I did.

If you are not a close evaluator of your investments, at least check the morningstar ratings of your funds – that is probably something you can do in about 5 min.

JonJanuary 19, 2010 at 11:04 am

@SB. Wow, I never thought about diversification across different accounts, I’ve always tried to obtain it in each account. My wife and I each have IRAs and 401Ks with a handful of mutual funds represented in each one. I’ll have to take a look and see what the best offerings are in each. How do you handle rebalancing in that situation, though?

Michael Harr @ Wealth...UncomplicatedJanuary 20, 2010 at 8:08 am

@basicmoneytips – I hesitated to post this, but think it’s something that needs to be added to the discussion.

Your story is one that has been repeated many thousands of times. Investment Strategy A doesn’t work, so go to Investment Strategy B. Later, I suspect, you will find Investment Strategy B not working and move on to Investment Strategy C….and on and on.

This is a common problem for all investors in that you assemble a group of investments, the market tanks (albeit this one was in magnificent fashion) and then you dump your previously ‘well designed’ strategy for a new one that you hope will be better.

Instead of asking questions like why did fund managers P and Q hold onto stocks Y and Z, you should turn your attention to the mirror. Why were you fully invested in stocks? Why didn’t you hold a more diversified portfolio (diversification with significant risk reducing benefits cannot be achieved by holding a single asset class or category)?

Ultimately, it sounds like you are chasing returns and are guilty of believing that you can outpace the market alone. This is highly improbable over the long run (no offense, it’s just that individual investors and even retail brokers have far less information and tools at their disposal than high profile fund managers…it’s an asymmetric information thing).

Rather than citing all of the research in this field, I’ll make my case in the plainest terms possible. The fundamental fact with investing is that your returns are dictated by your risk tolerance and not the other way around. As you have demonstrated, when the market took a bath in the sewer, you pulled out of your investment strategy. This means that your portfolio had more risk than you were comfortable with.

Now, you are attempting to reduce risk by investing in individual stocks. While the perceived risk may be lower, it’s likely that the real risk is much higher than when you entrusted your money to American Century and Legg Mason.

I say all of this not to be a hard on you, but simply to get you to rethink your investing strategy. It would probably be beneficial to answer two key questions: (1) Do I firmly believe that active managers (humans, that is) can outpace indices? and (2) Do I firmly believe that I can outpace active managers AND the indices?

Also, Morningstar ratings are neat, but not particularly useful other than eliminating 1 and 2 star performers. Beyond that, 3, 4, and 5 star rated funds typically cycle up and down depending on when their investment style is in favor. During the late 1990s, Janus had a slew of 5-star funds. During the first half of the 2000s, they fell to 3-stars or worse. During the 1990s, American Funds had a slew of 3-star funds. Since 2000, they have an abundance of 4 and 5 star funds. The difference is that Janus is a growth investment house overall and American Funds is a value-conscious investment house.

The takeaway here is that you need to know your investment managers and the style that they favor. If you know this, you’ll know when they’re susceptible to underperformance and when to expect outperformance of the broader markets. For example, when the market is on fire, I know that growth at any price (GAAP) managers will torch the market. I also know that if I’m holding deep value funds, they’ll likely be underperforming at the same time. However, if the entire market is in free fall, I know both will get hammered and that’s why I’ll need some money tucked away in cash and bonds.

By the way, I never invested with Miller’s fund because I never could get a good feel for his investment style (not to mention the high expenses). If I don’t understand the style, I keep looking.

S. B.January 21, 2010 at 12:57 pm

@Jon. Regarding rebalancing, I’m not highly structured about it, so I just use new contributions to move things in the right direction. In other words, I tend to just make new contributions to the funds that are below target percentage.

This works quite well for me. I realize this approach won’t work very well if you’re not currently contributing a lot to your accounts. Also, some people take a more formal approach to their rebalancing, and want to have it rebalanced correctly every quarter or year or whatever. People who want that structure might have issues with my approach.

Daddy PaulJanuary 23, 2010 at 5:38 am

One fund per category is all you need. Then select the best fund.

AnthonySeptember 13, 2011 at 11:33 pm

You can over-invest so to speak. Here in Australia, self managed super funds are all the rage at the moment.